Risk Management in Financial Planning

Over the years I have changed tremendously as an investor. A decade ago, when I was in my mid twenties, I hardly cared about risk management. I was predominantly into equities. The idea of investing in a fixed income product like a corporate bond or a provident fund account was as uninteresting as managing risks.

With time I have realised that investing without an eye on future will work only until you reach a certain age – I draw that line at 30.

What is Risk

Risk is the possibility of an unexpected happening which in the financial context could result in below expected returns or worst still – in total loss.

In financial planning, the types of risks which are ignored most frequently are not of business failure or the possibility of a stock market crash. They are mostly far more basic in nature like the risk of INFLATION, i.e. the fact that the purchasing power of your money will go down with time as prices of goods and services increase. Particularly in India where inflation rate regularly peaks out in the 7-9% range, it is extremely important to protect your investments against this risk. Naturally, having all your money in a government bond or in a bank fixed deposit paying 8% interest p.a. will not protect you from this risk.

Other Investing Risks:

DEFAULT OR CREDIT RISK: When buying bonds or secured debt instruments, the risk is that the borrower may not be able to pay interest or principal back on time. This risk will not exist when buying sovereign debt or government bonds as governments are always able to print currency as a last recourse but they will pay back one way or another.

LIQUIDITY OR MARKETABILITY RISK: Particularly relevant for traders, liquidity risk stems from the fact that an active trading market for a security may not exist and hence the investor may not be able to sell his securities. The perfect example for this is – corporate bonds (or real estate and art works) where retail investors in particular will find it hard to find buyers. So while corporate bonds may pay a high rate of interest in comparison to bank fixed deposits, remember – it may be difficult to find a ready buyer and in times of need, the investor may have to sell the asset below its intrinsic value.

A balanced portfolio should allocate not more than 20-30% in assets which face liquidity risks, not counting residential property.

RE-INVESTMENT RISK: The risk that existing cash flows may not get re-invested at the same rate of return. This is mostly a worry in a falling interest rate environment.

INTEREST RATE RISK: The risk that the RBI will change interest rates. This could run both ways depending on the investor’s exposure to an asset. For someone with a floating rate home mortgage, falling interest rates are good as they bring down the investors home mortgage EMI. At the same time for someone who invested in a government or corporate bond or in a bank fixed deposit, falling interest rates will reduce his monthly payouts.

At the same time the face value of bonds have an inverse relation with interest rates. A rise in interest rates results in failing bond prices and vice versa. This is because when interest rates fall, the new bonds start getting issued at a lower rate of interest and hence arbitrageurs rush in to buy the old bonds which pay a higher rate of interest. The price of the old bond rises until the cash flow from the old bond matches that of the newly issued bonds i.e. the bonds issued later at the lower rate of interest. The reverse happens when interest rates rise.

Investors also must factor in BUSINESS RISKS which are the risks specific to a particular business or the industry in which the business operates. The best way to tackle this is to make a well diversified portfolio with asset classes and stocks from different industries.

Investors and company’s who take exposure to assets overseas must also factor in EXCHANGE RATE RISKS – i.e. the risk that even though the investment in the underlying asset does well, overall the investor may not profit on account of depreciating domestic currency.

It is extremely critical to monitor your investments carefully from time to time along with your investment adviser. While it is a bad idea to shuffle your portfolio or stocks on a monthly basis, it must be done periodically based on general economic outlook and interest rate environment.

The importance of Past Trends in Risk Management

When making an ideal portfolio, look at the past trend of an asset before allocating any of it in your basket of assets. For a good portfolio aiming to achieve a reasonable return (~ 18% p.a. over 7 years) it is important to quantify risk and calculate how much the return falls over / under the past average over a given period of time.

Standard Deviation

Standard deviation is the average by which actual returns for given period could differ from the expected returns. To calculate the standard deviation:

[1] Start with the average return of the asset class for a given period.

[2] Calculate deviations for each period of the average.

[3] Square these deviations and add the numbers.

[4] Calculate square root of this sum.

[5] Divide [4] by the square root of the number of observations to get standard deviation.

In the above example, the standard deviation for BSE Sensex as a whole = 37.12. Keep in mind however that standard deviation as a measure of risk analysis is only indicative. So while estimated returns in stocks may be up / down by 37.12, the actual returns may not be the same.

Rule – Higher the standard deviation, more risky the investment will be volatile and move in a wider range, especially over a shorter period of time.

Simple Rule on Risk Management

Standard deviation is only indicative and should be used to balance the portfolio based on other assets in the basket.

For example if a portfolio is pre-dominantly focused on high interest bearing corporate bonds, the asset manager may want to allocate some portion of the portfolio to a high risk – high reward product to achieve higher returns, irrespective of the fact that such a product may have high standard deviation compared to other safer options. At the same time for a portfolio highly concentrated with equities, an asset manager may want to balance things with a safe 10-12% interest bearing corporate bond which has a standard deviation of 1-3%.

What is of most important in financial planning is defining your goals. Once you are sure that you are trying to achieve an X% return, the task of risk management becomes far easier.

Last updated: 29th May, 2015

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Rajat Sharma is a well known stock market analyst and commentator. He has covered Indian markets for over a decade and is regarded for consistently identifying early stage investment opportunities. Attorney by qualification, Rajat has done extensive work for improving corporate governance and disclosure standards.